Adjustable-Rate Mortgage (ARM) Pros and Cons

The Benefits and Drawbacks of ARMs and How They Work

A key decision buyers face when shopping for a home loan is choosing between a fixed-rate mortgage and an adjustable-rate mortgage (ARM). ARMs can be appealing because they typically offer lower initial interest rates, which can lead to short-term savings. For example, an ARM might be ideal for someone planning to relocate in a few years or expecting an increase in income that will make higher payments more manageable. This type of loan comes with unique risks and benefits that homebuyers should understand before making a decision.

Adjustable-Rate Mortgage Pros

The pros and cons of ARMs largely revolve around how the interest rate affects monthly mortgage payments and overall costs, but there are a few other considerations as well. This section highlights the potential benefits of choosing an ARM.

Lower Introductory Interest Rates

ARMs have an introductory period where the interest rate is fixed and typically lower than the rate of a fixed-rate mortgage. This initial fixed period lasts for 3, 5, 7, or 10 years depending on the loan terms. A popular option is a 5/1 ARM, where the interest rate stays the same during the first 5 years of the loan, and then adjusts annually based on current interest rates up to a certain limit called the lifetime cap.

This introductory period can benefit homebuyers because they'll likely pay less interest than they would with a fixed-rate mortgage. It particularly benefits those who plan to own their home for only a few years or refinance to a fixed-rate mortgage after the introductory period ends.

Lower Initial Monthly Payments

Monthly payments may initially be lower with an ARM because of the typically low introductory rate during the first few years of the loan. This initial rate is usually less than the rate of a fixed-rate mortgage, resulting in lower monthly payments during this phase of the ARM. This can be appealing to borrowers who plan to sell or refinance their home before the adjustable period begins.

Interest Rates Could Decrease Over Time

An ARM's interest rate has the potential to decrease over time because the loan's rate is tied to an index that reflects current market conditions. After the introductory period ends, the interest rate usually adjusts once a year based on this index plus a margin determined by the lender. If market interest rates decrease, the interest rate on the mortgage may also decrease when it comes time for the yearly adjustment. This feature of ARMs can be beneficial in a declining interest rate environment, as homeowners may get lower rates without needing to refinance.

Refinancing Options

Homeowners with ARMs often consider refinancing to gain more financial stability or better loan terms. Refinancing involves paying off your current mortgage and getting a new one, often switching from an adjustable-rate to a fixed-rate mortgage. This can be especially helpful in securing consistent monthly payments or locking in a low rate. For homeowners planning to stay in their home long-term, refinancing to a fixed-rate loan can also reduce the overall interest paid over the life of the loan.

Refinancing an ARM to another ARM can also be a smart option, depending on market conditions and your financial goals. This strategy is often used to secure a new introductory period with a lower interest rate, especially when the original ARM is nearing the end of its fixed-rate phase. As with any refinancing decision, it's important to weigh potential savings against closing costs and the possibility of future rate increases.

Interest Rate Caps

While homeowners who have ARMs may experience rate increases, interest rate caps exist to limit how much the interest rate can go up, providing protection from drastic spikes in monthly payments. If the market rate exceeds your rate cap, your interest rate will only adjust up to the cap. There are three main types of interest rate caps: initial, periodic, and lifetime caps. The initial cap limits how much the rate can increase after the first adjustment, the periodic cap limits how much it can change in either direction during adjustment periods, and the lifetime cap sets a maximum rate over the life of the loan. These caps help ensure that rate increases, as well as rate decreases, on your mortgage stay within certain bounds.

Adjustable-Rate Mortgage Cons

While many features of an ARM can work in the homebuyer's favor, there may be some downsides to consider. This section highlights the potential drawbacks of choosing an ARM.

Monthly Payments Could Go Up

ARMs run the risk of higher monthly payments if market rates go up since the interest rate is tied to a financial index that fluctuates. For example, if you have a 5/1 ARM with an initial rate of 3% for the first five years and the index your loan is tied to increases by 2% after the introductory period ends, you'd suddenly find yourself paying 5% interest. This could significantly raise your monthly mortgage payment and throw off your finances.

Interest Rates Could Increase

As previously mentioned, interest rates can increase after the ARM's initial fixed period, leading to higher monthly payments and more interest paid overall during the life of the loan. This could lead to a loss in savings and uncertainty in your budget. Depending on your loan term, even an increase of 1% during the adjustable period could noticeably raise your monthly payment.

Less Predictability

Compared to other types of mortgages, ARMs are considered less predictable because the interest rate (and subsequently, the monthly payment) can change periodically based on market conditions. While ARMs often start with a lower initial rate, there's the possibility that it could significantly increase after the initial fixed period ends. This variability makes it harder to make long-term financial plans, as future payments could rise beyond your budget if rates go up.

Penalties for Refinancing

Some lenders will charge a fee, known as a prepayment penalty, if you pay off your ARM early. This goes for refinancing, selling your home shortly after purchasing, or making large extra payments within a certain time frame. Lenders utilize this fee to recoup lost interest from early payoff, so it's important to review your mortgage agreement before taking any of these actions to avoid unexpected costs. Not all lenders charge prepayment fees. Freedom Mortgage home loans do not have prepayment penalties.

Adjustable-Rate Mortgages Today

ARM rates are primarily determined by an index—such as the Secured Overnight Financing Rate (SOFR)—which is used by most ARMs, plus a fixed margin set by the lender. The market rate changes based on broader economic conditions like inflation and Federal Reserve policies. As market indexes change, the interest rate on an ARM typically adjusts annually.

Other factors that influence the rate for a particular borrower's ARM include their credit history, loan amount, loan-to-value (LTV) ratio, and specific terms of the loan. The LTV ratio compares the loan amount to the property's value to help lenders assess risk. Specific terms of the loan might include rate caps and how many years the initial fixed-rate period is. Together, these elements determine the initial interest rate and limit how it can change over time.

ARM Alternative

The main alternative to an adjustable-rate mortgage is a fixed-rate mortgage. A fixed-rate mortgage retains the same interest rate and monthly payment over the entire life of the loan, which is typically 15, 20, or 30 years. If you're looking for an alternative to an ARM, most types of mortgages offer a fixed-rate option, including conventional loans and government-backed programs like FHA, VA, and USDA loans.

What Do ARM Pros and Cons Mean for You?

Deciding if an ARM is right for you ultimately depends on your financial and homeownership goals. ARMs offer an introductory period where the interest rate is fixed and usually lower than that of a fixed-rate loan, allowing for potential savings. This makes them a popular choice for homeowners who plan to sell or refinance their home within a few years. On the other hand, ARM payments may become less predictable after the introductory period ends, making them riskier than fixed-rate mortgages. If the ARM's pros outweigh the cons and reflect your needs, you can get prequalified with us today.